Major Loophole In Senate Financial Reform Bill, Derivatives Reform May Be Illusory

The pending financial reform bill in the Senate may not accomplish President Barack Obama’s goal of reforming the unregulated derivatives market, potentially wasting the nation’s best opportunity to fix a broken financial system and tarnishing the legacy of those claiming to clean up the markets.A section of the bill dealing with derivatives, financial instruments that transfer risk, contains a major loophole, according to an email from a consumer-advocacy organization to the Senate Banking Committee obtained by the Huffington Post. The loophole is wide enough to undermine the whole effort to reform a part of the financial market ” those derivatives traded between financial firms, like AIG, outside of any government oversight ” that’s largely blamed for worsening the financial crisis.“The derivatives market is where a lot of the big, risky financial bets by companies like AIG took place,” Obama said on April 16. “There are literally trillions of dollars sloshing around this market that basically changes hands under the cover of darkness. When things go wrong, as they did in AIG, they can bring down the entire economy, and that’s why we’ve got to bring more transparency and oversight when it comes to derivatives and bring them into a framework in which everybody knows exactly what’s going on, because we can’t afford another AIG.” The president added that he would veto legislation that “does not bring the derivatives market under control.”The financial regulatory reform legislation, which is being shepherded through the Senate by Banking Committee Chairman Christopher Dodd (D-Conn.), attempts to rein in the OTC derivatives market by mandating that most trades go through a clearinghouse, a facility that executes trades for parties that are required to post collateral and mark their positions daily to prevailing market prices. So, rather than two financial firms trading with each other ” with no oversight ” they’d now have to go through this central point. It would shed more light on the market and allow for government regulators to more effectively police it, reformers and Obama administration officials argue.Standard contracts and those not involving so-called “commercial end users” ” firms like Coca-Cola and General Electric that use derivatives as insurance against currency and interest-rate fluctuations, for example ” will be required to go through these clearinghouses. The problem, however, is that there’s apparently little consequence if firms evade the requirements, according to the email sent to a Banking Committee staffer by Americans for Financial Reform, an umbrella organization of consumer advocacy, public affairs and union groups arguing for reform. Some of these potential loopholes were first identified by Zach Carter of AlterNet.“[T]here is no consequence for counterparties who enter into uncleared swaps even after a finding by the [Commodity Futures Trading Commission] or [Securities and Exchange Commission] that the swaps must be cleared,” the email reads. The bill “does not prohibit the use of uncleared swaps and, even more egregious, expressly states that no swap can be voided for failure to clear.”In other words, if parties to a swaps contract ” a type of derivative that involves regular payments over a specified time period ” do not trade via a clearinghouse when they’re supposed to, there’s no penalty, the group argues. Also, those swaps can’t be deemed invalid because of this evasion.Furthermore, the email points out, even though federal regulators may require that a swap be cleared, they can’t mandate a clearinghouse to accept it.Parties wanting to enter into a typical derivatives contract usually go through a middleman called a Futures Commission Merchant (FCM). The entities will then take the contract and submit it to a clearinghouse. These merchants have the authority to reject contracts.The biggest futures commission merchants are owned by the largest banks, according to data collected by the CFTC. The largest banks also act as the dealers of derivatives. The big banks dominate the market. They also stand to lose the most revenue because of the increased transparency.“While [the bill] requires counterparties to submit all swaps for clearing, it does not address the issue of a swap that is submitted but rejected”¦ The explicit authorization to evade clearing establishes a perverse incentive,” the email argues.In short, if a swap is rejected it can continue to be traded “under the cover of darkness.” The big banks can decide when to reject a swap.“Moreover, [the bill] prohibits the CFTC from forcing a [clearinghouse] to accept a swap for clearing. Since clearinghouses have no incentive to list a swap that regulators deem must be cleared, and there is no consequence for trading an uncleared swap, counterparties are likely to exploit this loophole and continue to use uncleared swaps in an unregulated marketplace,” the email states.“Further, [the bill] states that a swap that does not clear may not be deemed void or unenforceable. The lack of an express ban on uncleared swaps”¦ converts the clearing requirement into a mere suggestion,” according to the email.The email suggests a fix to strengthen this “mere suggestion” into a requirement.Kirstin Brost, a spokeswoman for the Senate Banking Committee, said in an email that the current bill calls for “serious penalties” if parties don’t comply with the requirements of the legislation. She pointed to a Friday memo prepared by the Congressional Research Service, the in-house research unit for members of Congress and their staffs, that outlines the possible criminal and civil sanctions.For example, the CFTC can levy fines up to “triple the monetary gain” of each person that violates a regulation. It also can suspend or revoke a bank’s registration, or bring criminal charges.This depends, though, on who’s leading the CFTC. The current chairman, Gary Gensler, appears to be committed to cleaning up the market, imposing order, and fighting vigorously to ensure the legislation is as tough as possible. He’s among the few policymakers actively fighting against loopholes for special interests, like companies that want to evade the clearing requirement ” which would require higher costs ” by claiming an exemption. The legislation already features this exemption.Gensler, though, is a political appointee. There’s no guarantee future chairmen will be as committed to policing the market, which makes the legislation that much more important.

A Saturday email to a CFTC spokesman requesting comment was not immediately returned.Estimates vary as to how much of the market will be impacted by the proposed derivative rules. The Bank of International Settlements estimates that if all open OTC derivatives contracts were closed out at prevailing market prices, they’d be worth about $21.6 trillion as of last December, or 50 percent more than the nation’s total output last year. The CFTC roughly estimates that as much as 90 percent of the market will have to go through a clearinghouse.Of the 1,030 U.S. commercial banks reporting derivatives activity in December, just five ” JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs and Wells Fargo ” dominated the market. Those five, which also are the five largest banks in the country by total assets, represented 97 percent of the total activity in the U.S. banking system, according to national bank regulator the Office of the Comptroller of the Currency. As of March 31, those five giants collectively held $8.6 trillion in total assets, according to Federal Reserve data. That’s equivalent to 60 percent of U.S. gross domestic product (GDP) last year.“Clearing and exchange trading are at the heart of reform, mitigating risk, reducing leverage and forcing accountability on [the] derivatives marketplace,” said Sen. Blanche Lincoln, an Arkansas Democrat who oversees the CFTC as chairman of the Agriculture Committee, during a May 12 speech on the Senate floor. Lincoln wrote the derivatives section of the bill; it was modified by Dodd before it was incorporated into the overall financial reform bill.Lincoln’s staff is “willing to get this serious loophole blocked,” according to person familiar with the negotiations. The Senate Banking Committee “will have to agree with Senate Agriculture’s willingness to see this loophole blocked,” the source added.READ the email below:READ about the penalties:Derivatives Rules ” Penalties For Evasion More on Financial Crisis

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Major Loophole In Senate Financial Reform Bill, Derivatives Reform May Be Illusory